~ 我看青山多妩媚，料青山见我应如是 The mountain looks so beautiful in my eyes, that it reminds me of myself

THE GAME CHANGERBy George Soros 2009-02-04

In the past, whenever the financial system came close to a breakdown,the authorities rode to the rescue and prevented it from going overthe brink. That is what I expected in 2008 but that is not whathappened. On Monday September 15, Lehman Brothers, the US investmentbank, was allowed to go into bankruptcy without proper preparation. Itwas a game-changing event with catastrophic consequences.

For a start, the price of credit default swaps, a form of insuranceagainst companies defaulting on debt, went through the roof asinvestors took cover. AIG, the insurance giant, was carrying a largeshort position in CDS and faced imminent default. By the next day HankPaulson, then US Treasury secretary, had to reverse himself and cometo the rescue of AIG.

But worse was to come. Lehman was one of the main market-makers incommercial paper and a large issuer of these short-term obligations toboot. Reserve Primary, an independent money market fund, held Lehmanpaper and, since it had no deep pocket to turn to, it had to “breakthe buck” – stop redeeming its shares at par. That caused panic amongdepositors: by Thursday a run on money market funds was in full swing.

The panic then spread to the stock market. The financial systemsuffered cardiac arrest and had to be put on artificial life support.

How could Lehman have been left to go under? The responsibility liessquarely with the financial authorities, notably the Treasury and theFederal Reserve. The claim that they lacked the necessary legal powersis a lame excuse. In an emergency they could and should have donewhatever was necessary to prevent the system from collapsing. That iswhat they have done on other occasions. The fact is, they allowed itto happen.

On a deeper level, too, credit default swaps played a critical role inLehman’s demise. My explanation is controversial and all three stepsof my argument will take the reader to unfamiliar ground.

First, there is an asymmetry in the risk/reward ratio between beinglong or short in the stock market. (Being long means owning a stock,being short means selling a stock one does not own.) Being long hasunlimited potential on the upside but limited exposure on thedownside. Being short is the reverse. The asymmetry manifests itselfin the following way: losing on a long position reduces one’s riskexposure while losing on a short position increases it. As a result,one can be more patient being long and wrong than being short andwrong. The asymmetry serves to discourage the short-selling of stocks.

The second step is to understand credit default swaps and to recognisethat the CDS market offers a convenient way of shorting bonds. In thatmarket the asymmetry in risk/reward works in the opposite way tostocks. Going short on bonds by buying a CDS contract carries limitedrisk but unlimited profit potential; by contrast, selling creditdefault swaps offers limited profits but practically unlimited risks.

The asymmetry encourages speculating on the short side, which in turnexerts a downward pressure on the underlying bonds. When an adversedevelopment is expected, the negative effect can become overwhelmingbecause CDS tend to be priced as warrants, not as options: people buythem not because they expect an eventual default but because theyexpect the CDS to appreciate during the lifetime of the contract.

No arbitrage can correct the mispricing. That can be clearly seen inUS and UK government bonds, whose actual price is much higher thanthat implied by CDS. These asymmetries are difficult to reconcile withthe efficient market hypothesis, the notion that securities pricesaccurately reflect all known information.

The third step is to recognise reflexivity – that is to say, themispricing of financial instruments can affect the fundamentals thatmarket prices are supposed to reflect. Nowhere is this phenomenon morepronounced than in the case of financial institutions, whose abilityto do business is dependent on confidence and trust. That means that“bear raids” to drive down the share prices of these institutions canbe self-validating. That is in direct contradiction to the efficientmarket hypothesis.

Putting these three considerations together leads to the conclusionthat Lehman, AIG and other financial institutions were destroyed bybear raids in which the shorting of stocks and buying of CDS amplifiedand reinforced each other. Unlimited shorting was made possible by the2007 abolition of the uptick rule (which hindered bear raids byallowing short-selling only when prices were rising). The unlimitedselling of bonds was facilitated by the CDS market. Together, the twomade a lethal combination.

That is what AIG, one of the most successful insurance companies inthe world, failed to understand. Its business was selling insuranceand, when it saw a seriously mispriced risk, it went to town insuringit, in the belief that diversifying risk reduces it. It expected tomake a fortune in the long run but it was destroyed in short order.

My argument raises some interesting questions. What would havehappened if the uptick rule on shorting shares had been kept, ineffect, but “naked” short-selling (where the vendor has not borrowedthe stock in advance) and speculating in CDS had both been outlawed?The bankruptcy of Lehman might have been avoided but what would havehappened to the asset super-bubble? One can only conjecture. My guessis that the bubble would have been deflated more slowly, with lesscatastrophic results, but that the after-effects would have lingeredlonger. It would have resembled more the Japanese experience than whatis happening now.

What is the proper role of short- selling? Undoubtedly it givesmarkets greater depth and continuity, making them more resilient, butit is not without dangers. As bear raids can be self-validating, theyought to be kept under control. If the efficient market hypothesiswere valid, there would be an a priori reason for imposing noconstraints. As it is, both the uptick rule and allowing short-sellingonly when it is covered by borrowed stock are useful pragmaticmeasures that seem to work well without any clear-cut theoreticaljustification.

What about credit default swaps? Here I take a more radical view thanmost people. The prevailing view is that they ought to be traded onregulated exchanges. I believe they are toxic and should be used onlyby prescription. They could be used to insure actual bonds but – inlight of their asymmetric character – not to speculate againstcountries or companies.

CDS are not, however, the only synthetic financial instruments thathave proved toxic. The same applies to the slicing and dicing ofcollateralised debt obligations and to the portfolio insurancecontracts that caused the stock market crash of 1987, to mention onlytwo that have done a lot of damage. The issuance of stock is closelyregulated by authorities such as the Securities and ExchangeCommission; why not the issuance of derivatives and other syntheticinstruments? The role of reflexivity and the asymmetries identifiedearlier ought to prompt a rejection of the efficient market hypothesisand a thorough reconsideration of the regulatory regime.

Now that the bankruptcy of Lehman has had the same shock effect on thebehaviour of consumers and businesses as the bank failures of the1930s, the problems facing the administration of President BarackObama are even greater than those that confronted Franklin D.Roosevelt. Total credit outstanding was 160 per cent of gross domesticproduct in 1929 and rose to 260 per cent in 1932; we entered the crashof 2008 at 365 per cent and the ratio is bound to rise to 500 percent. This is without taking into account the pervasive use ofderivatives, which was absent in the 1930s but immensely complicatesthe current situation. On the positive side, we have the experience ofthe 1930s and the prescriptions of John Maynard Keynes to draw on.

The bursting of bubbles causes credit contraction, the forcedliquidation of assets, deflation and wealth destruction that may reachcatastrophic proportions. In a deflationary environment, the weight ofaccumulated debt can sink the banking system and push the economy intodepression. That is what needs to be prevented at all costs.

It can be done – by creating money to offset the contraction ofcredit, recapitalising the banking system and writing off or down theaccumulated debt in an orderly manner. They require radical andunorthodox policy measures. For best results, the three processesshould be combined.

If these measures were successful and credit started to expand,deflationary pressures would be replaced by the spectre of inflationand the authorities would have to drain the excess money supply fromthe economy almost as fast as they had pumped it in. There is no wayto escape from a far-from- equilibrium situation – global deflationand depression – except by first inducing its opposite and thenreducing it.

To prevent the US economy from sliding into a depression, Mr Obamamust implement a radical and comprehensive set of policies. Alongsidethe well- advanced fiscal stimulus package, these should include asystem-wide and compulsory recapitalisation of the banking system anda thorough overhaul of the mortgage system – reducing the cost ofmortgages and foreclosures.

Energy policy could also play an important role in counteracting bothdepression and deflation. The American consumer can no longer act asthe motor of the global economy. Alternative energy and developmentsthat produce energy savings could serve as a new motor, but only ifthe price of conventional fuels is kept high enough to justifyinvesting in those activities. That would involve putting a floorunder the price of fossil fuels by imposing a price on carbonemissions and import duties on oil to keep the domestic price above,say, $70 per barrel.

Finally, the international financial system must be reformed. Far fromproviding a level playing field, the current system favours thecountries in control of the international financial institutions,notably the US, to the detriment of nations at the periphery. Theperiphery countries have been subject to the market disciplinedictated by the Washington consensus but the US was exempt from it.

How unfair the system is has been revealed by a crisis that originatedin the US yet is doing more damage to the periphery. Assistance isneeded to protect the financial systems of periphery countries,including trade finance, something that will require large contingencyfunds available at little notice for brief periods of time. Peripherygovernments will also need long-term financing to enable them toengage in counter-cyclical fiscal policies.

In addition, banking regulations need to be internationallyco-ordinated. Market regulations should be global as well. Nationalgovernments also need to co-ordinate their macroeconomic policies inorder to avoid wide currency swings and other disruption.

This is a condensed, almost shorthand account of what needs to be doneto turn the global economy around. It should give a sense of howdifficult a task it is.

The writer is chairman of Soros Fund Management and founder of theOpen Society Institute. These are extracts from an e-book update toThe New Paradigm for Financial Markets – The credit crisis of 2008 andwhat it means (PublicAffairs Books, New York)